Founded in the 1970s by a group of G-10 central bankers, The Basel Committee on Banking Supervision (BCBS) is the body that constructs the voluntary guidelines that dictate the Basel Accords which influence the international banking system.
Today, the BCBS consists of central bank representatives and regulatory authorities from all of the G-20 economies. Set forth by the BCBS, the recommended policy is enforced by each Basel Committee member nation’s respective regulatory bodies. The first Basel Accord was published in 1988 and in 2009 the BCBS published Basel III in response to the worldwide financial crisis of the late 2000s. The three primary areas of Basel III are capital adequacy, stress testing and liquidity requirements.
The Basel III Liquidity Coverage Ratio
The primary liquidity requirement introduced by Basel III is the Liquidity Coverage Ratio (LCR). The LCR is designed to absorb unexpected outflows of short-term funding with the aim of strengthening the resiliency of financial institutions (FIs) if a severe economic stress were to arise. It is the first regulatory requirement for FIs to maintain a specified level of liquidity.
Qualifying FIs would be required to maintain a minimum LCR by holding an adequate amount of high-quality liquid assets (HQLA). The equation is quite simple. The LCR is calculated by dividing a financial institution’s HQLA (the numerator) by its net cash outflows over a specified period – typically 21 to 30 days depending on the FI (the denominator).
Initially, the LCR was determined to be 100% by 1 January 2014. Instead, the implementation was changed to 60% by 1 January 2015 and a 10% increase in the mandatory LCR ratio every year until 1 January 2019, at which time the LCR requirement would be 100% and fully implemented. The Fed has proposed a more aggressive LCR implementation, where qualifying FIs must have an LCR of 80% by 1 January 2015 with a 10% increase every year until 1 January 2017, at which time the LCR would be required to be 100%.
Assets that qualify as a HQLA are those easily convertible to cash that experience virtually no loss in value if a severe stress event were to occur. Those with low bid-ask spreads and a high number of market participants and high trading volume are generally considered most liquid. Consistent with Basel III’s recommendations, HQLA are being divided into three categories; level 1 assets, level 2A assets and level 2B assets.
The agencies are proposing that level 1 liquid assets be Federal Reserve Bank (FRB) reserves, Treasury securities whose principal and interest payments are explicitly guaranteed by the full faith and credit of the US government, foreign central bank reserves, certain sovereign debt obligations and certain sovereign and multilateral organisation securities.The aforementioned level 1 liquid assets are considered HQLAs without limit to amount and receive no haircut when calculating the LCR numerator.
Level 2A liquid assets are those that exhibit strong liquidity characteristics in the marketplace, but are generally not considered as liquid as other securities; for example US Treasuries. Level 2A HQLA include government sponsored enterprise (GSE) securities; those with the implicit guarantee of the US government. Additionally, GSE used when calculating the LCR numerator are given a 15% haircut.
Lastly, level 2B liquid assets are included in the HQLA calculation. Much of the scrutiny surrounding the LCR surrounds level 2B liquid assets as it includes certain investment grade publicly traded corporate debt securities and publicly traded equity securities included in the Standard & Poor’s (S&P) 500 Index or an equivalent satisfactory index. Level 2A and 2B HQLA cannot exceed 40% of total HQLA and level 2B HQLA alone cannot exceed 15% of total HQLA.
Assets that meet the HQLA qualification can be classified as held-to-maturity (HTM) or available-for-sale (AFS).
Municipal Securities Excluded from HQLA
Not mentioned in the Fed’s proposal are municipal securities. Not just below investment grade municipal securities, all municipal securities are not to be considered HQLA. Accelerating the controversy of the Fed’s municipal exclusion, medium-to-low grade corporate bonds and specific equities are included in the LCR calculation. This is perplexing considering that general obligation municipal bonds receive a 20% Basel III risk-weight, while GSE debt – considered a level 2A HQLA – also receives a 20% Basel III risk-weight.
Municipal bond market participants are aghast by the exclusion. Many would argue that high-quality municipal bonds are indeed liquid enough to be considered in the LCR numerator and there will undoubtedly be an outcry from municipal market participants, especially from banks which are among the largest holders of municipal securities.
Impact on the Municipal Bond Market
The Fed’s decision to excluded municipal securities from the LCR calculation could potentially have a grave impact on the municipal bond market as a whole. As noted earlier, FIs hold large amounts of municipal securities in their investment portfolios. It can be assumed that the Fed’s current proposal will dampen demand for municipal bonds, even though, on a tax-equivalent basis, municipal bonds tend to outperform most other fixed-income securities typically held by banks. If a case were to arise where a bank needed to choose between yield and satisfying the LCR requirement, the LCR requirement would take precedence over yield.
Additionally, banks account for a much of the liquidity in the municipal bond market. With banks having a disincentive to purchase municipal securities, there is the potential for, at the very least, a modest reduction in demand and hence, liquidity. With this reduction in liquidity, small municipalities throughout the United States may have a more difficult time raising low-cost funds for public projects and essential services.
Ironically, current tax law actually gives banks the incentive to hold certain municipal securities. Banks and FIs are allowed to deduct 80% of the carrying cost or interest expense allocable to municipal bonds deemed bank-qualified. This tax deduction provides a tax incentive to banks and tremendous amounts of capital to the municipal sector.
The Fed’s proposal in nowhere near finalised, as the notice of proposed rulemaking (NPR) has an extended comment period ending 31 January 2014. Inevitably, there will be an uproar from municipal market participants; both from municipal issuers and banks. Those close to the matter feel strongly the municipal exclusion will not be upheld, but if it is, the municipal bond market will definitely be impacted. One thing is for sure, the municipal exclusion will make for a very lively comment period.
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